Making money from companies on the verge of bankruptcy.

When companies are in financial trouble, we often hear about investors walking away with hefty sums of money. This seems counterintuitive, but it stems from the fact that investors have purchased the company’s debt, rather than its stock.

This is often referred to as distressed debt investing, and it’s a common practice among hedge funds and many institutional investors.

With distressed debt investing, an investor consciously purchases the debt of a troubled company—often at a discount—and seeks to profit if the company turns around.

In many cases, investors still walk away with payments even if a company goes bankrupt, and in some cases, distressed debt investors actually end up as owners of the troubled company.

Getting Debt on the Cheap

There is no strict rule for when to categorize a debt as “distressed” but it generally means that the debt is trading at a significant discount to its par value. So for example, you may be able to purchase a $500 bond for $200. In this case, the discount comes because the borrower is at risk of defaulting. And indeed, investors can lose money if the company goes bankrupt. But if investors believe there can be a turnaround and are ultimately proven right, they can see the value of the debt go up dramatically.

An investor who purchases equity shares of a company instead of debt could make more money than debt investors if a company turns itself around. But, shares could lose their entire value if a company goes bankrupt.

Debt, on the other hand, still retains some value even if a turnaround doesn’t happen.

Gaining Control

When an investor purchases a company’s distressed debt, they are not only making a purchase but will often end up with some control of the business. Entities like hedge funds that buy large quantities of distressed debt will often negotiate terms that allow them to take an active role with the troubled company.

Additionally, distressed debt investors can achieve priority status in being paid back if a company goes bankrupt.

When a company declares Chapter 11 bankruptcy, a court will usually determine the priority order of creditors who are owed money. Those involved in distressed debt are often some of the first people paid back, ahead of shareholders and even employees. Sometimes, this can result in the creditors actually taking ownership of a company. When this happens, the distressed debt investors can make a fortune if they are successful in turning the company around.

Risk Management

Anytime an investor purchases debt, such as in the form of a government or corporate bond, they run the risk of the borrower defaulting. That’s why most investors are urged to study the creditworthiness of a borrower to determine the likelihood of getting their money back. The risk of default is also why debt from less creditworthy organizations will generate a higher return for the investor.

With distressed debt investing, there is a very real risk of the investor walking away with nothing if the company goes bankrupt.

Moreover, these funds are often very skilled at spreading out risk and, when possible, partnering with other firms so they aren’t overexposed if one investment defaults.

Most importantly, skilled hedge fund managers understand the value of diversification in investing. It’s unlikely that distressed debt would comprise a significant percentage of a hedge fund’s full portfolio.

Distressed Debt for Average Investors

Generally speaking, the Average Joe is not going to be involved in distressed debt investing. Most people are better off investing in stocks and standard bonds because it is simply and far less risky. But it is possible for an individual to access this market if they choose. Some companies offer mutual funds that invest in distressed debt, or include distressed debt as part of a portfolio.

The Franklin Mutual Quest Fund from Franklin Templeton Investments [NYSE: MQIFX], for example, includes distressed debt in its holdings along with undervalued companies and cash. Oaktree Capital is another firm offering individual investors access to distressed debt through private vehicles.

It’s helpful for investors to understand the possibilities that distressed debt offers, but it rarely makes sense in a typical retirement portfolio. Sticking with stocks, mutual funds and investment grade bonds is a safer and more sensible path to wealth for most people.